Some people you just shouldn’t trade against

From Barrons:

Look Who’s Selling (Registration Required)
By DOUGLAS A. KASS

THERE ARE SOME PEOPLE you just shouldn’t trade against. Among them: George Soros, Stanley Druckenmiller, Steve Cohen, Ed Lampert and Sam Zell — yes, the Sam Zell who recently agreed to sell his Equity Office Properties Trust to the private equity firm Blackstone Group. Shares of EOP, the largest real-estate investment trust specializing in commercial properties, have nearly doubled from the mid-20s in the fall of 2002 and now, at almost 50 a share, the value of one of Zell’s jewels is relatively full. Zell accepted cash and the associated tax bill, which supports the view that he thought the price was rich.

Announcement of the deal fueled a huge collateral move in REIT shares-which already were making a very large advance, both absolutely and relative to the market. The sector now sells at 19.5 times cash flow (they call it “funds from operations” in REIT-land) and at almost 120% of net asset value, which is ridiculously high by any historic standard. Over the past 15 years, the dividend yield on the REITs has averaged about 1.1 percentage points above the yield on the 10-year Treasury note — but today the average REIT dividend yield is 1.25 percentage points below the 10-year yield.

Bulls see pension funds and other institutions having a continued interest in diversifying into real estate, and they mark the role of private equity in a series of acquisitions in the sector. They also expect that rental rates for commercial properties will continue to rise and that nationwide vacancy rates (now the lowest in seven years) will keep falling. These trends thus justify lofty acquisition prices and high cash-flow multiples. REIT optimists believe that the industry is relatively immune to an economic downturn and that institutional funds will forever flow into real estate’s coffers and drive share prices ever higher.

If Sam Zell is selling, why is Blackstone buying? Why did Aesop’s scorpion sting the frog? It’s what they do.
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Leverage is the major weapon of most private equity outfits. Private equity fund managers don’t goose the cash flows better than the previous owners could — it’s unlikely they know the businesses better than the owners who operated them for years.

They simply rely on the kindness of strangers. Institutional investors, such as pension funds and university endowments, supply them with the initial capital and bankers lend to them afterward.

Bubbles always have similar ingredients. They are founded on the belief in a new paradigm, a long uninterrupted term of prosperity in which more and more funds are plowed into the prosperous sector. If capital is cheap and plentiful, leverage will be abused, and a new class of marginal buyer will be encouraged to take asset values to ludicrous levels.
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The now famous stock-market bubble of the late 1990s was much the same, only simpler. Margin debt was widely available, and day traders could take very large positions for a couple of hours without being called upon to back their positions with much capital. Individual investors began to expect uncommon investment returns regularly basis, and their expectations further inflated the stock market bubble — until it popped nearly seven years ago.

After the stock-market bubble was pierced, the Federal Reserve loosened dramatically. Generational lows in interest rates spurred record low mortgage rates and an unprecedented housing construction boom. Home prices became the new source of speculative profits, supported by such innovations as interest-only amortization schedules and mortgages issued without credit checks (for hefty fees up front). The enabling mortgage lending community lifted home prices well beyond buyers’ ideas of affordability.

SPECULATORS TOOK OVER and began to take a disproportionate role in the residential-real-estate market. Home prices kept on rising until they were elevated to levels that were out of reach for most buyers. Eighteen months after demand evaporated we still don’t know where the bottom will be.

Today’s boom in commercial real estate, like the bubbles that preceded it, has been fueled by the belief in a long, uninterrupted economic boom and a continued stream of equity and debt capital. Both could come to an end.